<p>All contracts governed by New York law (and most other state contracts) imply a <b>covenant of good faith and fair dealing</b> in the course of performance. The covenant embraces a pledge that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract. Good faith performance of a contract emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party while bad faith may be overt or may consist of inaction and has been recognized to include evasion of the spirit of the bargain, lack of diligence and slacking off, willful rendering of imperfect performance, abuse of a power to specify terms and interference with or a failure to cooperate in the other party's performance.</p>
<p>The covenant is often invoked by a party who is unhappy with the intention of the other party to the contract to take action. A claim concerning the covenant is often raised in a situation where one party to the contract intends to take action that is not prohibited by the express terms of the contract and the other party seeks to prevent or attack such action by claiming it violates the covenant.</p>
<p><b>For PE or venture investors: What would an investor do to take action with respect to a portfolio company to protect or advance the investor's interests? Glen Banks, a partner in the New York office of Fulbright & Jaworski L.L.P. provides his insight.</b></p>

<p>Can both Mike Bloomberg and Hank Paulson be wrong? Both have highlighted the threat to U.S. supremacy in the financial service sector. But some policy makers are making counterpoints that claim the U.S. is currently and will continue to be the global leader in finance.</p>
<p>But the stats are the stats, e.g. in 2006, more money was raised on AIM ($31 billion) than NASDAQ ($29 billion). This week, Joe Bartlett, formerly Of Counsel at Fish & Richardson PC and now Of Counsel, Sullivan & Worcester LLP and Editor of the Encyclopedia of Private Equity compiles the statistics. <a href="http://vcexperts.com/vce/news/buzz/archive_view.asp?id=504">Download the raw data and reports here.</a></p>

<p>While it is only the fourth or fifth inning of Chairman Chris Cox's turn on the pitcher's mound at the SEC, knowledgeable observers are giving the Chair <b>extremely high marks</b> for his sophisticated handling of open issues confronting the Agency. Like all skillful politicians Cox understands how to work with the various constituencies which have mattered to his office and its proper functioning ... including, of course, the Congress and the business and financial community. From this corner, he appears to be the master of the 'flagpole', meaning he feels out the landscape by running proposals 'up the flagpole' and gauging the strength of the support and opposition before he makes a definitive move.</p>
<p>Want to know what the latest issue the SEC is raising up the flagpole? Hint--it has to do with raising capital.</p>

<p>The strong positive trend in venture valuations continues--especially in the Bay area. In the 2nd quarter:</p>
<ul>
<li>Up rounds exceeded down rounds for the 14th quarter in a row (81% up vs. 11% down, with 8% flat). The ratio of up rounds to down rounds was tied with 1Q07 for the highest ratio since our survey began in 2002.</li>
</ul>
<ul>
<li>The Fenwick & West Venture Capital BarometerT showed a 74% average price increase for companies receiving venture capital in 2Q07 compared to such companies' previous financing round. This was the second largest increase since our survey began (1Q07 had a 75% increase). This increase was driven in part by 12 financings in which the purchase price of the stock sold in the financing was at least three times higher than the prior round. Of these financings, seven were in Web 2.0 and related fields.</li>
</ul>
<p>Other U.S. venture industry-related results for the quarter included the following:</p>
<ul>
<li>The amount invested by venture capitalists in the U.S. in 2Q07 was approximately $7.4 billion in 717 transactions, compared to $7 billion raised in 584 transactions in 1Q07. The amount invested this quarter was the highest amount of venture investment in a quarter since 4Q01</li>
</ul>
<p>What does this mean? Has Web 2.0 been over-hyped? This week, we turn to Barry Kramer and Michael J. Patrick of Fenwick & West LLP as they review West Coast financing trends and terms.</p>

<p>While the carried interest debate has quieted recently in Washington DC--it continues to be debated in the EU--particularly in the UK. Which is why it's important to watch the issue closely, especially how the BVCA (British Private Equity and Venture Capital Assn.) reacts--or should I say how the BVCA has played their hand pro-actively (hint hint to our US counterparts).</p>
<p>The BVCA has clearly identified the reasons why it is appropriate to charge venture and private equity as capital gains tax, which include: the significant co-investments made by executives as a condition of getting a carried interest (usually a very high proportion of the individual's net worth), the entrepreneurial nature of private equity ownership, and the fact that full income tax is paid on the market salaries received by executives. They also say that around half of funds never pay any carried interest at all, and that one in four loses capital, highlighting the speculative nature of the interest.</p>
<p>This week, pan-European law firm <b>SJ Berwin</b> delivers a comprehensive look at the history, the politics, the policy and the likely outcomes of the debate.</p>

<p>The SEC voted unanimously to adopt a new antifraud rule under the Investment Advisers Act of 1940. The new rule will make it "a fraudulent, deceptive, or manipulative act, practice, or course of business <b>for an investment adviser to a pooled investment vehicle</b> to make false or misleading statements to, or otherwise to defraud, investors or prospective investors in that pool. The rule will apply to all investment advisers to pooled investment vehicles, regardless of whether they are registered under the Advisers Act. Read more from Goodwin Procter's Business Law and Financial Services Group.</p>

<p>It is common for entrepreneurs to offer to their investors preferred stock in their new ventures to raise capital. Preferred stock terms have strong protection for investors and in the end no debt is put on the company.</p>
<p><b>Venture debt</b> is another form of financing companies. The investors loan money to the company instead of buying an ownership stake. This form of security is seeing an increasing use among venture-backed companies. But what are the ramifications? Read a brief overview of venture debt by John E. Richards of Brigham Young University and <a href="http://vcexperts.com/vce/community/forums/topic_view.asp?topic_id=360">comment in our blog</a> (all responses to be posted in the next Buzz).</p>

<p>In response to the <a href="http://vcexperts.com/vce/news/buzz/archive_view.asp?id=495">Buzz of the Week from August 30th, 2007</a>, Samuel Shafner, Co-Chairman of the International Practice Group at Burns & Levinson LLP offers counterarguments and additional insights to the <b>Hallmark Capital</b> legal issue and the SEC's response. As always, we welcome all feedback from our readers on this and any other topic from the world of Private Equity and Venture Capital.</p>

<p>The staff of the SEC's Division of Market Regulation issued a letter to Hallmark Capital Corporation ("Hallcap") <b>denying Hallcap's request</b> for no-action relief regarding the requirement to register with the SEC as a broker-dealer pursuant to Section 15(b) of the Securities Exchange Act of 1934 ("Exchange Act"). Hallcap stated in its request letter that the financial services it currently provides to companies fall within three general categories:</p>
<ul>
<li>assisting small businesses in raising equity and debt capital;</li>
<li>assisting small businesses with mergers and acquisitions;</li>
<li>and providing issuers with strategic business consulting services.</li>
</ul>
<p>If you (as an issuer) or your portfolio company are raising capital through a broker-dealer (or an unregistered finder), read the update from Sean O'Malley, attorney at Goodwin Procter LLP as he reviews legal developments of note.</p>

<p>On Monday, April 16<sup>th</sup>, Kara Scannell of <i>The Wall Street Journal</i> reported that the SEC was exploring the relaxation of its long standing policy <b>against charter provisions compelling arbitration securities litigation</b>. There has been nothing official from the SEC, other than the conversation with Scannell. But, the article is a straw in the wind.</p>
<p>Ironically, as the U.S. is leading towards what many believe is a more balanced and productive landscape by authorizing compulsory arbitration, the European Union is considering opening its legal systems up to the U.S. based class action litigators ... Bernstein Litowitz, Milberg Weiss ... etc. </p>

<p>The extraordinary success of the managers of private equity funds has provoked controversy in the United States.<p><p>A major issue has to do with the entitlement of labor unions to sit at the table when a buyout is negotiated. The unions argue egregious returns are being achieved on the backs of the target's rank and file, who have no voice in the process.<p><p>In an interview with Andy Stern of the Service Employees International Union in The Wall Street Journal on May 30, Stern said that the SEIU wants to "engage ... the buyout kings," with whom he "much prefers working" versus "their public company counterparts."<p><p>The verb "engage" needs definition. What exactly does the union have in mind? The answer is contained in a formal SEIU study, "Behind the Buyouts: Inside the World of Private Equity".</p>

<p>It is perhaps surprising that the headline economic terms of European private equity funds have remained pretty constant for decades - despite the changing market environment in which they are being raised. If a fund cannot raise enough to close it is rarely because its terms are too rich, and improving the terms is unlikely to help. And an oversubscribed fund with a good track record will still find it hard to raise management fees or carried interest rates above well established market norms.</p>
<p>In our annual review of fund terms and conditions, we have once again confirmed that there has been no change in the core economic terms, and - despite a little pressure on management fees - we are not seeing any real moves by investors to disturb the status quo. But, as in previous years, the interesting data is in the detail. <i>(Editor's note--see the VC Experts sister site--<b><a href="http://pedatacenter.com">PEDataCenter.com</a> for the Fund Formation Database)</b></i></p>
<p>First, to reconfirm the basic terms: management fees range from 2.5% for smaller (venture) funds, between 1.75% and 2% for larger and mid market buyout funds, and fall to 1.5% (sometimes a shade less) for mega funds (which we categorise as those raising 2 billion euro or more). Carried interest rates are stuck firmly at 20% and (in Europe) still operate on a "fund as a whole" basis (so the 20% is of profits of the fund not, as is common in the United States, of the profits of each deal). Carry is typically only paid out when investors have received a hurdle rate of return of, normally, 8% (but sometimes 6% or 7%).</p>

<p>Private equity and venture capital firms have always been justifiably proud of their corporate governance model. Alignment of interest between investors and managers is difficult to achieve in listed companies, with a diverse and largely indifferent shareholder base. But it is much less of a problem when a dominant shareholder, and invariably one with real industry and business expertise, oversees the executive management team. Elaborate, expensive (and often ineffective) devices to ensure that managers act in the best interests of the company - rather than their own - are not necessary, and the executive team works with the shareholders to deliver real business improvements, and to maximise shareholder value.</p>
<p>In a speech delivered in Amsterdam this week, Javier Echarri - the Secretary-General of the European Private Equity and Venture Capital Association (EVCA) - emphasised that the private equity model involves "thorough strategic planning and focus on value creation over longer time horizons", and enhances the effectiveness of the board. This is in advance of the new U.K. "Law on directors' duties" that resembles some of the U.S./Delaware law. In sum, it codifies:</p>
<ul>
<li>there is no distinction between executive and nonexecutive directors;</li>
<li>directors only owe their duties to the company and only the company can bring a claim for breach; and</li>
<li>minority shareholders will - as now - be able to bring a claim on behalf of the company for breach of duty, but only in exceptional circumstances and with the approval of the court.</li>
</ul>
<p>Read more from our friends at <b>SJ Berwin</b>, and download a PDF review of the new law and analysis for what it might mean for PE and VC investing both in Europe and on a global basis.</p>

<p>For those venture or private equity backed companies contemplating a middle-market merger or asset acquisition, buyers should take an adequate amount of time to assess the hidden deal risks within the Information Technology (IT) landscape. Middle-market companies may not have the vision, technology architecture, or appropriate skill mix to support aggressive growth after the acquisition closes. IT due diligence involves more than filling out asset listings and checking off boxes. A skilled due diligence team understands that big EBITDA impacts can be found <b>within seven crucial areas.</b></p>

As cash hungry U.S. legislators talk about raising taxes on carried interest, our friends in the Private Equity business in the U.K. seem focused on other issues. Similar to the U.S. markets, the private equity industry in the EU has faced the full glare of the media spotlight, particularly in the UK - and much of this has been unsympathetic.</p> Unfortunately, the press has often compounded the negative image propagated by trade unions by repeating inaccurate assertions about the tax treatment of private equity. In particular, they have focused on shareholder debt - finance provided by investors by way of loan rather than equity - which was mentioned in an important speech recently. In fact, that speech - by the UK's Economic Secretary to the Treasury, Ed Balls - was actually very good news: it confirmed that the ability to deduct interest on loans taken out for business purposes from taxable profits is regarded as an industry norm, not only in the UK but internationally, and it confirmed that that principle is not under scrutiny in Britain.

<p>There is now an alternative to the public markets for private equity funds and hedge funds wishing to issue shares. The alternative is a newly-created private market that just may end up being the market of choice for funds if it proves to be viable. Goldman Sachs, as was reported in the Wall Street Journal, has developed a private market on which shares of funds will trade. The market is called "GS Tradable Unregistered Equity OTC Market" or GSTrUE. Oaktree Capital Management LLC, a Los Angeles-based investment firm with close to $42 billion in assets, was the first to sell its shares on GSTrUE. Oaktree raised $880 million in the private offering in May. And as of August 2nd, Apollo had filed to do the same. Is this a run around Sarbanes Oxley and public disclosure--or did publicity shy (compared to Blackstone) Oaktree make the right call? Many think they did.</p>

<p>Choosing the best business entity generally entails a two-tier analysis. First, the type of state law format or entity must be selected, from among a proprietorship or division, partnership, limited liability company, corporation, or trust. Both income and non-income tax considerations play a role in that choice. Second, assuming a particular state law format or entity, then its income tax classification must be determined. Obviously, that determination is based solely or almost entirely on income tax considerations.</p>
<p>LLCs are the most versatile entity from an income tax standpoint. LLCs can generally elect between being classified as a disregarded entity or partnership on the one hand, or a corporation on the other. If corporate classification is chosen or otherwise applies, then it may be possible to further elect between an S or C corporation. It often makes sense to set up a new business or venture as an LLC, or to convert an existing entity into an LLC, to minimize both income and non-income taxes. LLCs open up new possibilities in structuring mergers and acquisitions. LLCs can also be used to further estate planning goals. A business owner, accountant, or business law practitioner thus needs to have a good understanding of the many roles that can be played by LLCs and the potential tax savings they offer.</p>
<p>In the <b>last half</b> of a two-part detailed analysis, <b>George R. Goodman of Foley & Lardner LLP,</b> begins with a discussion of the non-income tax considerations in making the initial choice between an LLC and a state law corporation. Then, in a more detailed analysis, given the ability of LLCs to be classified at any time for income tax purposes, there is a detailed analysis of the income taxation of an LLC under each classification and the considerations relevant to a U.S. person in choosing among the income tax classifications.</p>

<p>Choosing the best business entity generally entails a two-tier analysis. First, the type of state law format or entity must be selected, from among a proprietorship or division, partnership, limited liability company, corporation, or trust. Both income and non-income tax considerations play a role in that choice. Second, assuming a particular state law format or entity, then its income tax classification must be determined. Obviously, that determination is based solely or almost entirely on income tax considerations.</p>
<p>LLCs are the most versatile entity from an income tax standpoint. LLCs can generally elect between being classified as a disregarded entity or partnership on the one hand, or a corporation on the other. If corporate classification is chosen or otherwise applies, then it may be possible to further elect between an S or C corporation. It often makes sense to set up a new business or venture as an LLC, or to convert an existing entity into an LLC, to minimize both income and non-income taxes. LLCs open up new possibilities in structuring mergers and acquisitions. LLCs can also be used to further estate planning goals. A business owner, accountant, or business law practitioner thus needs to have a good understanding of the many roles that can be played by LLCs and the potential tax savings they offer.</p>
<p>In the first of a two-part detailed analysis, <b>George R. Goodman of Foley & Lardner LLP,</b> begins with a discussion of the non-income tax considerations in making the initial choice between an LLC and a state law corporation. Then, in a more detailed analysis, given the ability of LLCs to be classified at any time for income tax purposes, there is a detailed analysis of the income taxation of an LLC under each classification and the considerations relevant to a U.S. person in choosing among the income tax classifications.</p>

<p>The law of patent licensing has been plagued for years by uncertainty regarding what can happen when the licensee, after entering into a royalty-bearing license agreement, wants to challenge the validity of the licensed patents and thus contest its obligation to pay royalties to the licensor. A recent Supreme Court decision issued on January 9, 2007, <i>MedImmune v. Genentech,</i> clarifies one area of uncertainty, but several others remain. As a result of this decision, both licensors and licensees should reassess their options and their strategies, both before and after entering into license agreements.</p>
<p>This week, we look to Eric M. Reifschneider and Robin J. Lee of Cooley Godward Kronish for more insight into this high stakes matter.</p>